Sub-Prime Debt: A Ticking Time Bomb Once Again

As I wrote two days ago, the world’s central bankers have spent the last seven years pushing interest rates toward zero and below. In response, millions of financial operators and capital users have scoured the globe looking for ways to profit from the lowest interest rates in history. Their favourite method was to create and sell higher yielding debt to institutional and individual investors desperate for income, thereby creating the next sub-prime take-down that will be worse than 2008.

In 2008, sub-prime mortgages were the weapons of mass destruction that blew up the financial system. This time around, in my opinion, it will be sub-prime (junk) corporate debt.

How bad are the numbers? A new report by S&P Global identifies 251 “at-risk” high-yield corporate issuers (those with a B- or lower credit rating and a negative outlook) who collectively owe an enormous $359 billion in debt, the highest level since the Great Recession of 2009. As S&P’s head of global fixed income research noted, issuers at this low end of the high yield (HY) rating spectrum have historically been ten times more likely to miss bond payments than other HY issuers.

Energy issuers are driving a disproportionate share of HY stress with 12-month trailing default rates increasing to 26.9% at the end of July. But none of this data concerns HY investors who have been on a buying spree so far in 2016 pushing spreads back toward all-time lows…

This does not make sense. The HY market seems to be assuming that because rates remain low, troubled issuers will be able to refinance or borrow more. However, a key leading indicator for the junk debt market—recovery ratios—say otherwise. If these stressed corporate borrowers were still credit-worthy, the recovery rates during liquidation would be higher. Lenders are sometimes willing to refinance junk debt market when default rates turn up if they can recover a significant amount of their capital in bankruptcy. But that’s no longer the case. Recovery rates on defaulted debt have plunged to record lows.

As JPMorgan’s Peter Acciavatti notes, recovery rates in 2016 are extremely low. For high-yield bonds, the recovery rate YTD is 10.3%, well below the 25-year annual average of 41.4%. Final recovery rates in 2015 for high-yield bonds were 25.2%, compared with recoveries of 48.1% in 2014, 52.7% in 2013, 53.2% in 2012, 48.6% in 2011 and 41.0% in 2010. As for loans, recovery rates for first-lien loans thus far in 2016 are 24.5% compared to an 18-year average of 67.2%.The record collapse in recovery rates is shown below.

So, to summarize: default rates are soaring, recovery rates are dropping dramatically BUT high-yield bond prices have surgedon the back of $200 billion per month of central bank asset purchases and the resulting low to negative yields on higher quality paper. What could possibly go wrong, dear reader?

h/t @BondVigilantes

There is a vast and growing gap between ‘real’ junk bond asset values (upon liquidation or bankruptcy) and the artificially supported ‘prices’ seen in the market. Something has to give.

Who is Wayne Wile?

Wayne Wile is an international investment advisor with more than five decades of experience in wealth management. He has spent the majority of his career working with institutional and high net worth investors, seeking to mitigate risk while optimizing portfolio performance.

Wayne began work in the mailroom of a brokerage firm when he was 17 years of age and rose to a senior executive position. He was recruited for key jobs with several nationally recognized investment firms in Canada before striking out on his own.

Wayne’s methods as a trader are governed by simplicity and self-discipline. He says that losses are the children of greed and fear while profits are the spawn of patience and trend-following. “Time is always on your side. Let the market tell you what it wants to do and keep it company. Never chase an idea you think you have missed. There is always another one coming along.”

Wayne is especially opposed to sophisticated trading strategies that try to predict the future based on mathematical analysis of historical data. “These systems routinely destroy far more wealth than they create,” he says. “Only a highly intelligent, well-educated individual would be foolish enough to do this stuff. Successful traders need to stop analyzing and learn to listen to what the market is telling them every day.”

Wayne resides in the Cayman Islands but considers himself a citizen of the world.